Evil grain-speculating OVERLORDS will starve us ALL

Darn those evil speculators in food! You know, them, those men in offices playing with futures and derivatives in wheat and corn: they're starving the poor you know! For there is evil in the marketplace and we know where evil comes from: men in offices playing with money. Therefore the evil must be caused by said playing with commodity derivatives, right?

“Mr Sarkozy has admirably decided to make tackling high food prices a priority for France’s presidency of the G20 this year. Less admirably, he has clearly already made up his mind to blame speculators regardless of the evidence,“ the Wall Street Journal blogger wrote.

That is, of course regardless of the evidence of his own officials who pointed out that speculators are doing no such thing.

We've also had similar hysteria from the World Development Movement (WDM) in this report (PDF/36 pages/937KB) of theirs. “How banking speculation causes food crises” indeed. That certain forms of speculation are what solves food crises, diminishes them, reduces their impact, isn't something they've seemed to notice: nor that the actual speculation they're complaining about, futures and other derivatives, has near to no effect at all on current food prices. Whether the WDM is wilfully blind to it all or simply misinformed is up to you to decide.

Leave aside food for a moment and think of the regular cycles we've had in the memory market: this has been going on since I first thrilled to tech support coming around to upgrade me to a whole 640kb of RAM. Any of us who has been playing with hardware over the years knows the dreary repetition of the story. Someone builds a new silicon fab pumping out umpteen pieces of giggity sized memory and the market goes into a tailspin pricewise.

You can even afford enough RAM to run a Microsoft operating system without a second mortgage. Then there are more people in the market – all using more RAM – and chips become more scarce. Clever people spot this and start hoarding the chips, thus making a fortune as prices soar. At some point the price is high enough that someone out Far East can persuade the bankers to let him have $5 billion to build another new fab and when it comes online prices collapse again and off we go.

Now we could say that those hoarders are profit-gouging bastards: or we could say that they're actually, by the price rises they induce, doing us all a favour. High prices make us all consider our use of RAM, meaning that we'll perhaps not upgrade that operating system: it also leads the would be fab owner to think more about building another and the banks to lend him the money. Prices thus act as a signal of scarcity, making us economise on consumption and others increase production, thus actually solving, over time, that very scarcity the prices are signalling.

Medieval merchants were wheat-hoarding bastards

Back to food: this is exactly the argument that Adam Smith put forward to explain the activities of a wheat merchant (Wealth of Nations, Book IV, Chapter V, start at para 40, here, for a decent dose of 18th century prose). When wheat is plentiful (although he calls it corn – the English did not call maize corn until some time later), say after a harvest, the merchant buys it up and stores it.

He then waits until prices have risen before he sells it. If his expected shortage in the future doesn't arrive then he's shit out of luck and loses money. If it does, then the happy populace now have wheat to eat. For, and here's the crucial point: what our merchant, our speculator, has done is move prices through time.

If we all ate wheat like it was that bounteous time just after harvest all the time then we would run out of wheat entirely before the next harvest. Prices would, at that point, become really rather high. However, by buying in the time of plenty, he's raised prices in that time of plenty: thus making everyone consume a little less in that Harvest Festival gluttony. He's also lowered prices in the Hungry Time (in medieval times, the six weeks before the harvest was indeed known as this, it was the worst time of year for food supplies) because he has at least some grain available rather than none.

So we've reduced price volatility, stretched the available supply over more time, possibly even stopped some starvation, by someone being enough of a bastard to speculate on food prices.

Now note, this is physical speculation, actual purchase, taking delivery and storage.

Derivatives speculation, using futures and options, has less effect on prices. It gives us information about what people think prices might be in the future, for sure, but it will only affect today's prices if high future prices lead to that actual physical storage and hoarding. Which could happen, to be sure, but won't necessarily.

All of this leads us to what people like M Sarkozy are trying to say and what the WDM are screaming about. The latter, in their report linked above, come right out and say that as more people are playing with food derivatives, this is what has been pushing up food prices. This is nonsensical, in the absence of any physical hoarding. For a start, WDM seems not to realise than a futures market is zero sum: for any profit made by someone then someone else must have made an equal and opposite loss.

For everyone going long (betting on a price rise) someone else must have made an equal and opposite bet going short (betting that prices will fall). That's just how these markets are. It really doesn't matter to spot (current) prices whether three people are betting £50 or 30,000 are betting $50bn: there will be an equal and opposite number of people long as there are short, by definition.

So it absolutely cannot be that “more people speculating increases food prices”.

WDM's second point is that more speculation means more volatility in prices: something that almost all economists would regard with a very jaundiced eye. For the general assumption is that futures act upon prices as does Smith's wheat merchant: they reduce price volatility. Fortunately, the WDM, in its own report, provide us with an example of this.

In the 2006/8 price rises, it notes that there's a deep and liquid speculative market for wheat and corn (maize), while there's only a very thin one for rice. And yet it was rice that was vastly more volatile in price in this period: despite the fact that it was wheat and maize which people were turning into ethanol for cars (the true cause of the price rises) rather than rice.

Speculative markets reduce price volatility, rather than increase it

Turning to current price rises, yes, there's lots of speculation going on. But is that just providing us with signals about future possible prices or is it actually driving up today's prices as well? Actually causing people to go hungry, possibly even starve, right now? From the above we can see that this is only possible if physical hoarding is increasing: if grain stocks are growing because people expect to be able to earn more in the future.

“OK, how can speculation affect this picture? The answer is, it has to work through accumulation of inventories – physical inventories. If high futures prices induce increased storage, this reduces the quantity available to consumers, and it can raise the price. And you can, in fact, argue that something like this has been happening for cotton and copper, where there are apparently large and growing inventories.

But real hoarding, keep the grain in the granary type of speculation, that would be a good thing. For it moves prices through time and thus reduces price volatility – encourages hunger now rather than starvation later.

Smith pointed this out 235 years ago. Just how long does it take to get an idea into the popular consciousness?